Promised land

Of all the economic reforms enacted by the Chinese Communist Party since 1978, the liberalization of the property market was without doubt the most drastic: Some call it the largest transfer of wealth from state to private ownership in history. It allowed millions of people to find better housing and a place to invest their savings, in the process creating some of China’s most valuable companies – and wealthiest people.

But the wealth it created was not distributed equally. In no other sector in this nominally socialist country does the gap between rich and poor contrast so sharply. Even as the rich flip luxury penthouses amongst themselves, recent university graduates are taking up residences in bathrooms and storage containers.

To ameliorate this gross inequality – and its attendant social dissatisfaction – the central government has launched an ambitious new welfare program: constructing 36 million government-subsidized housing units in the next five years that will shelter 20% of urban households. “Our determination is unswerving that special care will be given to the needy and low-income families to make sure they can afford housing,” said Premier Wen Jiabao.

As political theater, affordable housing is an easy way to provide popular cover to a power transition. Blaring declarations of government concern for the common people, it is hoped, will ensure the legacy of the current leadership and pave the way for a new group of leaders in 2012.

However, actually restoring balance to the property market will require a delicate touch. Much of the wealth of China’s middle class – not to mention its companies and local governments – is tied up in property. The sector is also a major employer. A drop in housing values would destroy a lot of paper wealth, potentially chilling consumption. This in turn would throw a wrench in plans to rebalance the economy and confound the strategies of multinationals that have bet heavily on the rise of the Chinese shopper.

Furthermore, big questions remain about how China’s social housing projects will be built and paid for. Ten million units are slated for construction in 2011 alone, requiring US$200 billion in investment – equivalent to about one-third of China’s economic stimulus package. But it will be local governments, not Beijing, that will do the heavy lifting when it comes to funding and implementation.

Finally, there is the question of what benefit the end-user will actually receive. Social housing projects in some countries have served the common good; in others they have created crime-ridden slums.

A clear need

In the past few decades, China’s construction companies and property developers have rushed to raise gleaming residential towers topped with penthouses and checkered the suburbs with luxury villas. Given that many of these developments remain lightly tenanted, it might seem strange that so many people still lack housing.

The problem, of course, is that while most of the Chinese population still cannot afford luxury villas, villas were built first, for sound commercial reasons. “In the 12 or 13 years since the industry was privatized, the basic housing needs of only the top 20-22% of the population have been met,” said Michael Klibaner, head of research for property consultancy Jones Lang LaSalle in China. “It’s not surprising that it’s the wealthiest 22%.”

Given across-the-board demand for all kinds of housing, profit-motivated builders rationally started out catering to the higher end of the market. Thanks to inflation, erratic stock markets and tight controls on investment, the wealthy had few places to park their money besides property, so they invested heavily, driving prices up. The result is the sold-out yet mostly vacant Chinese apartment complexes that puzzle foreign observers.

The lower classes are now clamoring for their chance at property ownership. The scale of demand is massive: 14-15 million new people are flowing into China’s cities each year; of those already living in urban areas, untold millions are still stuck in Soviet-style blocs or in dilapidated traditional row houses.

Can social housing fill this gap? On paper, Beijing has lined up enough funding to meet this year’s targets. However, the plan obligates the central government to provide only about 10% of the cash required. Local governments are meant to contribute another 7-15% out of their revenues from land sales, while about 60% will come from those who will ultimately own or rent social housing.

This leaves a funding gap of US$30-46 billion that the government is proposing to fill several ways, including using cash from state-owned insurers, pension funds and banks, or siphoning profits from the housing provident fund, which finances mortgages for low-income households. Each comes with its own pitfalls. Lending to social housing could put more non-performing loans on bank balance sheets; moving money out of different budgets could weaken other parts of the social safety net.

In fact, the funding tap seems to be sputtering already. State media reported in June that construction had begun on only 30% of this year’s target, leaving much to accomplish before the official deadline in November. Many developers are citing the scarcity of funding as a major reason for this delay, after China clamped down on bank lending in recent months.

“There are lots of projects but little cash around. It’s like we have ten pots but only eight lids,” one property executive griped to Shanghai’s Oriental Daily.

Stick or carrot?

The next question is who will step forward to build social housing – and how well? Low-priced housing projects generate profit margins of only around 5%, compared to more than 15% for commercial housing. This means that apart from publicly currying favor with the government, big developers like Vanke and Poly Real Estate have little incentive to participate. When they do, slim margins have encouraged some builders to skimp on materials. That preserves both guanxi and margins, but at the cost of building quality and residents’ safety.

However, caps on profit margins do not present an obstacle for every company, argued Wang Tao, head of China economic research at UBS Securities. State-owned builders – like China State Construction and China Metallurgical Group – are accustomed to earning margins of around 5% on commercial housing projects.

“People tend to say developers are not interested because they are operating with this kind of margin, this kind of model. But social housing does not need to be constructed by developers,” said Tao. “Developers often outsource projects to construction companies anyway.”

Assuming local governments find the cash and contractors to build the apartments, they still have plenty of reasons to put off construction. One of the most widely publicized fiscal challenges of local governments is their dependence on land sales for revenues – typically about 40%, according to Liu Li-Gang, head of Greater China economics at ANZ.

“Local governments don’t have the right incentives to provide social housing because they are required to provide land for free,” said Tao of UBS. “Traditionally they sold land at the monopoly price for a very high return, so there’s a conflict of interest there.”

The central government is aware that this system creates dangerous contradictions. For example, the lure of larger revenues from re-developing downtown plots is the source of many forced evictions and social unrest, including the spectacular bombing of a government building in Jiangxi province by a disgruntled evictee in May.

So far, though, there are few alternatives. Shanghai and Chongqing are testing property tax regimes that are a step toward reform, but the taxes remain limited in scope and unpopular with Chinese property owners. Any major change in funding mechanisms
for local governments remains a long way off.

Lacking fiscal carrots, the central government is relying on political sticks. It is requiring local governments to set aside 70% of the new land they sell for social housing and has made meeting construction targets a criterion in officials’ performance reviews. China’s vice premier and next probable paramount leader, Li Keqiang, announced in February that 2011 targets were mandatory, sending a clear message: Those who slack on implementation could see their careers stall in the coming regime.

Will officials choose cash now or career later? The answer may vary, but some are likely to try for both. Though local governments outwardly appear to be in step, there are signs that they are already taking evasive maneuvers to safeguard revenues.

According to Credit Suisse, the average transaction price for land sales fell 51% in the first four months of the year. This plunge may signal that local governments are temporarily hoarding their best plots while offloading the least desirable ones for affordable housing, even in the face of budgetary pressure – boding ill for Beijing’s hopes for genuine compliance.

There are also signs that localities may be meeting construction targets by massaging the data, a favored pastime in provincial statistics bureaus. While the government proclaimed that 3.7 million social units were completed last year – roughly 70% of the full-year target – those figures are difficult to verify on the ground.

Beijing required local governments to submit a detailed update this spring on how many social units they had constructed. The deadline came and went, but many local governments failed to turn in their numbers.

“We don’t really know how many projects there are,” said Dong Linfeng, an analyst at Business China Connect. “We know some, of course, but if you really dig into this information, it’s difficult to find the names of all these projects.”

Worthy of the name?

Even among the projects that are well publicized, it’s questionable whether some deserve the name of social housing – and the preferential policies that accompany it. One of the ways that China has been able to dramatically increase the scale of social housing construction is by expanding the definition of social housing itself. As with air pollution, ambitious social housing targets may be met by changing the methods of measurement.

For example, affordable housing in its traditional sense – units that are built on land auctioned by the local government and sold to the poor for low prices – makes up merely 20% of this year’s target, or 2 million units. Low-rent and “public-rent” units, which have maximum income limits high enough to include the lower-middle class, account for another 40% of the target.

The remainder of the 2011 target, an astounding 40%, is made up by slum renovations. This category includes relocating people from old housing downtown into new apartments, often on the outskirts of cities, a practice that has been common over the last decade but was only redefined as “social housing” last year.

Statistically, this is taking credit for something that would have happened anyway. Slum renovations afford developers clear advantages – mainly freeing up valuable urban land for higher-end developments – but their social benefit is dubious. Similar projects in the US have resulted in the creation of new suburban slums far from employers, good schools and public transport.

As the category of social housing has been expanded, project managers have followed step. Take the Huajing development, a modern, red brick project in southern Shanghai, which was originally supposed to be made up entirely of units designated for sale to low-income buyers when it began construction in 2008.

Had the developers stuck to the plan, Huajing would have become the largest such development in the city. But by late 2010, the project had been converted to a mixture of public-rent, low-rent and resettlement units. Huajing’s current developer, Shanghai Land Group, told China Economic Review that the change was due to Shanghai’s increased emphasis on public rental housing in 2010.

“In some parts of China, public housing is not that different from so-called commercial units,” said Hao Zhou, an economist at ANZ. “The price is not that different, but [developers] can say, ‘this is social housing,’ and get favorable policies from the central government.”

This ambiguity was probably built into the system intentionally. Housing the poor and quieting middle-class dissatisfaction is, after all, a herculean task. Some have pointed to the success of public housing projects in Singapore and Hong Kong as models for China, but even these small, tightly controlled states took decades to fully construct their systems. China has pledged to accomplish a far more ambitious project in just a few years, with fewer resources per capita than Hong Kong or Singapore had.

But if the definition and goals of the social housing program are deliberately left vague, the likelihood of statistical success increases.

“If in fact 50% or more of social housing winds up being commercially developed small- and medium-sized housing, it probably doesn’t look or feel that different from other stuff in the market. It’s maybe just positioned a bit lower than previous projects,” said Klibaner of Jones Lang LaSalle.

That’s better than nothing. China unquestionably suffers from a shortage of cheaper small- and medium-sized apartments – pent-up demand for such units has resulted in a surge of fraudulent applications for social housing units from people with higher incomes. The program can still help resolve this inventory imbalance. It will also have a positive influence outside of the property sector by boosting disposable incomes.

To be fair, some uncertainties with funding and participants remain because the program has only just begun. “It will come through just like the RMB4 trillion (US$618 billion) stimulus in late 2008,” said Wang Tao of UBS. “When the plan was announced, it’s a broad brush objective, but details will gradually fall into place.”

Ambitious targets are also motivational; by aiming high, the central government helps to ensure that more gets done.

Booms and busts

But even allowing for potential benefits, the long-term effect of the program is unclear. Intervening in the market is likely to create problems of its own – pent-up demand for higher-end properties, for example, or more non-performing loans on bank balance sheets. Policy meddling in real estate has exacerbated property booms and busts in the past.

Another area of uncertainty is what kind of investment instruments these homes will turn out to be. Individuals who buy affordable houses are prevented from reselling them within a certain window, usually five years.

But there have yet to be clear policies issued about what happens after that: Will owners be allowed to sell the units at open-market rates, or will profits for owners be capped? The risk here, of course, is that if owners perceive no advantage to upgrading or maintaining their homes, the new complexes will quickly become new slums. On the other hand, the government cannot afford rampant speculation in affordable housing.

Even if the experiment is successful, social housing is only part of the solution. To truly stabilize the residential housing market, China must face up to a laundry list of politically complicated issues: sorting out local government finances, stamping out the corruption that exacerbates the gap between rich and poor, improving the diversity and quality of other investment opportunities, and making it easier for Chinese investors to put their money overseas. A house this big will take time to get in order.

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